A large number of Italian politicians and academics claim that an eventual Italian exit from the euro would be desirable and painless. In support of this hypothesis, they point to the effects of Italy’s withdrawal from the exchange rate system established by the European Monetary System (EMS) in 1992.
On that occasion, only one single peak in the rate of returns on Italian bonds came about, as can be seen in the graph below showing the median rate of return on Italian bonds – and the inflation rate remained stable afterwards. But is it really certain that the two exits can be compared?
The EMS versus the Euro: A Comparison
The EMS was an arrangement designed to determine exchange rates among currencies at a predetermined fixed level, and did not foresee in any way the introduction of a single monetary unit. Central Banks continued to have total control of their monetary policy, aiming to keep exchange rate parity steady.
On the other hand, the Euro replaced national single currencies and is managed at an international level by the European System of Central Banks (ESCB), whose executive is represented by the ECB (European Central Bank).
Different Macro Environments
During the final period of the EMS, the Economic European Community (EEC) was already looking towards the future. The idea of the Economic and Monetary Union (EMU) was drawn up and, in December 1991, the twelve countries belonging to the EEC held a meeting in Maastricht to decide how to pursue the Euro project.
Fiscal and monetary agreements were reached and each country started to set the necessary reforms. Nations such as Italy made enormous efforts to put their own public finances in order so that they were eligible to adopt the single currency. That is why when Italy left EMS it suffered only insignificant consequences, concerning just its interest rates.
Indeed, Italy increased taxes and adopted certain key reforms, such as the Dini’s Government pension reform of 1995, to contain domestic demand and to prevent inflationary pressures coming as a result of its currency devaluation.
On the other hand, a potential exit of the Euro would find Italy in a completely different situation. Indeed, Italy would be coming from a position of several years of recession and poor GDP growth (which the graph below illustrates), accompanied with an increasing tax burden. Thus, it would be harder for the Italian Government to adopt the necessary measures to block subsequent inflation, especially if a competitive devaluation were to be decided.
The European Monetary System’s Demise
The EMS was abandoned because of several speculative attacks, especially concerning the Italian currency. The main speculative wave started with the result of a Danish referendum on joining the Economic and Monetary Union, which the Scandinavian country decided against. In spite of its limited range, this event contributed towards a growing perplexion about the concrete chances of completing the EMU among investors.
Central banks intervened massively in financial markets, trying to defend the parity between exchange rates at the time. Eventually, the contrasts between France and Germany caused the exchange parity to stop being defendable, leading Italy to head into a devaluation.
One of the most important reasons for this failure could be found in the idea of an ‘impossible trinity’. This expression stands for the incompatibility between a fixed exchange rate system, independent monetary policy, and the free movement of capital.
Indeed, an excessive monetary expansion in comparison to other countries, in addition to being ineffective, causes a gradual reduction of foreign reserves and forces the country to abandon the fixed exchange rate system.
On the contrary, the potential exit of the Euro is perceived and proposed as a miracle cure to solve all Italian problems. Particularly, many political parties want to return to a national currency and then devalue it in an attempt to stimulate exports and production. But, as economists say, there is no free lunch.
The positive effects of a devaluation would be outweighed by inflation, which would be tougher to deal with than it was in 1992. Inflation means a drastic reduction of workers’ real wages and a dramatic increase in the cost of every debt denominated in euros and dollars.
The Bottom Line
Despite a few similarities, EMS and EMU are strongly different arrangements with very different outcomes. The EMS only allowed its member countries to fix their exchange rates at predetermined levels. On the other hand, the EMU has more ambitious aims, and is part of a larger and more complex programme – the European Union.
The exit from the SME was reached only by allowing exchange rates to freely fluctuate. In contrast, leaving the Euro would have to be accompanied by several legislative decrees, from limiting the free movement of capital to interrupting international payments for the time required by the conversion. They are clearly very different things indeed.